Chapter 2 - Financial background: A Review of Accounting, Financial Statements and Taxes

1. Chapter 2 - Financial background: A Review of Accounting, Financial Statements and Taxes

2. The Nature of Financial Statements • Numerical representations of a firm’s activities for an accounting period • A picture of activities within the firm and between the firm and the outside • But can be counterintuitive

3. Accounts Receivable • Most sales are on credit • Seller receives a promise of later payment, rather than immediate cash • The seller records an account receivable as an asset • Net income may not = cash flow

4. Depreciation • Proration of an asset’s cost over its service life • Can be straight lined or accelerated • Cost recorded on the income statement does not = cash spent

5. The Nature of Financial Statements • Three Financial Statements • Income statement • Balance sheet • Statement of cash flows • Generated from the income statement and balance sheet

6. The Accounting System • A firm’s financial books are a collection of records in which money transactions are recorded • Double entry system • Accounting periods and closing the books • Implications • Stocks and flows

7. Table 2-1 A Typical Income Statement

8. The Income Statement • Sales • Cost and Expenses • Costs of Goods Sold • Expense • Depreciation • Gross margin • Earnings before interest and taxes (EBIT)

9. The Income Statement • Earnings Before Tax, and Tax • Net Income • Terminology: • Income = profit = earnings • Profit before tax (PBT) • Profit after tax (PAT) • Earnings before tax (EBT) • Earnings after tax (Net Income)

10. Earnings • Earnings • Also called net income • Paid out as dividends or retained in business • Retained Earnings (RE) • Each year earnings not paid as dividends become an addition to equity • Retained earnings account is cumulative earnings not paid out as dividends

11. The Balance Sheet • Lists everything a company owns and owes at a moment in time • All sources and uses of money must be equal • A firm’s money sources include creditors and owners • Borrowing creates a liability for repayment

12. The Balance Sheet • Two equal sides Assets = liabilities + equity • Assets and liabilities are arranged in order of decreasing liquidity Liquidity – ease with which an asset becomes or a liability requires cash

13. Table 2-2 A Conventional Balance Sheet Format

14. Assets • Cash • Checking balances plus currency • Marketable securities are liquid investments held instead of cash • Short-term, modest return, low risk • Accounts Receivable • Uncollected credit sales • Bad Debt Reserve: some credit sales will never be paid • Write Off: Remove bad debt from gross and reserve leaving net unchanged

15. Concept Connection Example 2-1 Writing Off a Large Uncollectable Receivable Gross accounts receivable $5,650 Bad-debt reserve (290) Net accounts receivable $5,360 Need to Write Off $435,000 Reserve 290,000 Expense $145,000 Reestablish Reserve (5%) 260,750 Profit Reduction $405,750

16. Assets • Inventory - product held for sale in the normal course of business • Work-In-Process Inventories (WIP) • Value added as inventory moves through production • The Inventory Reserve • Some inventory is unusable - balances reported net of reserve • Writing Off Bad Inventory • Missing, damaged, or obsolete items removed from gross and reserve leaving net unchanged

17. Assets • Overstatements • If assets are overstated, firm’s value is less than total shown on balance sheet • Current Assets • Become cash within a year • Include cash, accounts receivable and inventory • Fixed Assets • Long lived, depreciable, also called property, plant and equipment (PPE) • Useful life of at least a year

18. Assets • Depreciation • Spreads asset’s cost over its estimated useful life • Financial Statement Representation • Appears as an expense or cost • Accumulated depreciation appears on balance sheet reflecting a wearing out of the asset

19. Table 2-3 Fixed Asset Depreciation

20. Assets • Disposing of a Used Asset • The Life Estimate • Tax Depreciation and Tax Books • Government allows different depreciation schedules for tax purposes and financial reporting purposes

21. Concept Connection Example 2-2 Selling a Fixed Asset Accounting Cash Flow Revenue $4,000 $4,000 Cost (NBV) 2,500 Profit contribution: EBT $1,500 Tax (30%) (450) (450) Contribution: net income $1,050 Cash flow $3,550

22. Liabilities • What a company owes to outsiders • Accounts Payable • Arise when a firm buys from vendors on credit • Terms of Sale • Specify when payment is due on credit sales and the early payment discount • Understated Payables

23. Liabilities • Accruals • Recognize expenses and liabilities associated with incomplete transactions • Payroll Accrual • Current Liabilities • Require cash within one year • Payable and accruals are classified as current

24. Figure 2-1 A Payroll Accrual

25. Working Capital Total current assets = gross working capital Net Working Capital = Current Assets ─ Current Liabilities

26. Long Term Liabilities • Long Term Debt • The most significant non-current liability • Leverage • A business partially financed with debt is leveraged • Fixed Financial Charges • Interest must be paid regardless of profitability

27. Concept Connection Example 2-3 Leverage • A business is financed with equity of $100,000 • Net Income = $15,000 • Return on equity = 15% ($15,000/$100,000) • Calculate return on equity if $50,000 borrowed at an after tax interest rate of 10%

28. Concept Connection Example 2-3Leverage Borrowing levers return on equity up from 15% to 20%.

29. Equity • Common Stock • Preferred Stock • Has mix of characteristics of both debt and equity • Retained Earnings • All previous earnings not paid out as dividends • Capital • The sum of long-term debt and equity • Total Liabilities and Equity • Sum of the right-hand side of the balance sheet • Must equal total assets

30. Equity Accounts Illustration Three Separate Accounts Direct Investment by owners paying for stock Par value and paid in excess accounts Retained Earnings Illustration: 20,000 shares of $2 par sold for $8 Firm Earns $70,000 Pays dividends of $15,000 Common Stock ($2 x 20,000) $ 40,000 Paid in Excess ($6 x 20,000) 120,000 Retained Earnings ($70,000 - $15,000) 55,000 Total Equity $215,000

31. Net Income and Retained Earnings Beginning Equity + Net Income – Dividends + New Stock Sold = Ending Equity

32. The Tax Environment Taxing Authorities and Tax Bases • Income tax • Wealth tax • Consumption tax • Sales tax

33. Income Taxes—The Total Effective Tax Rate (TETR) Total effective tax rate (TETR) is the combined state and federal rate • State tax is deductible from income when calculating federal tax TETR = Tf + Ts (1 – Tf) where Tf = federal tax rate Ts = state tax rate

34. Progressive Tax Systems, Marginal and Average Rates • Progressive tax system • Brackets • Marginal and average tax rates

35. Capital Gains and Losses • Two major types of income • Ordinary income • Capital gains or loss and dividends

36. The Tax Treatment of Capital Gains and Losses • Capital gains historically taxed at lower rates • Holding period must be > 1 year for favorable tax treatment

37. Income Tax Calculations • Income taxes are paid by households and corporations according to the same basic principles • Tax is levied on a base of taxable income • But rate schedules for corporations and households are very different as are the rules for calculating taxable income

38. Table 2-4 Personal Tax Schedules - 2012

39. Personal Taxes Taxable Income • Wages, profits, interest and dividends are basic taxable income • Deductions are personal expenditures that can be subtracted from income before calculating taxes • Exemptions are fixed amounts per person that can be subtracted from income to arrive at taxable income

40. Concept Connection Example 2-4 Calculating Personal Taxes The Harris family had the following income in 2012: Salaries: Joe $55,000 Sue 52,000 Interest on savings acct 2,000 Interest on IBM bonds 800 Interest on Boston Bonds 1,200 Dividends - Gen Motors 600

41. Concept Connection Example 2-4 Calculating Personal Taxes In 2012 the Harris family: • Sold property for $50,000, paid $53,000 years earlier • Sold stock for $14,000, paid $12,000 years earlier. • Paid $12,000 interest on home mortgage • Paid $1,800 in real estate taxes. • Had $3,500 withheld from pay for state income tax • Contributed $1,200 to charity. • Have two children • Exemption rate is $3,800 per person. • Calculate taxable income and tax liability. • What are marginal and average tax rates?

42. Concept Connection Example 2-4 Calculating Personal Taxes Ordinary income: Deductions: Salaries $107,000 Mortgage interest $12,000 Interest 2,800 Taxes5,300 $109,800 Charity1,200 $18,500 Net capital gain or loss: Loss on property ($3,000) Exemptions: Gain on stock 2,000$3,800 x 4 = $15,200 Net capital loss ($1,000) Total Income $108,800 Taxable Income $75,100 (excludes dividends)

43. Concept Connection Example 2-4 Calculating Personal Taxes Use the married filing jointly schedule as follows: 10% of the entire first bracket $17,400 x .10 = $1,740 15% of the amount in the second bracket ($70,700- $17,400) x .15 = 7,995 25% of the amount in the third bracket ($75,100 - $70,700) x .25 = 1,000 Tax Liability $10,835 Tax on dividends $600 x .15 = 90 Total tax liability $10,925 Average tax rate: $10,925/$75,700 = 14.4% Marginal tax rate = bracket rate = 25% (15% if dividends or capital gains)

44. Personal Taxes • Tax Rates and Investment Decisions • Comparing municipal (muni) and corporate bonds • Interest on muni’s not subject to federal taxes • At same rate muni’s return is higher after taxes • If the rates differ, restate corporate to an after tax yield Multiply by one minus investor’s marginal tax rate (1 – marginal tax rate)

45. Concept Connection Example 2-5 Comparing Taxable and Tax Exempt Returns The Harris family (25% bracket) has a choice between an IBM bond paying 11% and a Boston bond paying 9%. Solution: IBM after tax = 11% x (1 - .25) = 8.25% < Boston = 9% Therefore prefer the Boston bond if risks are similar. If marginal tax rate is 15% 11% x (1 - .15) = 9.35% then prefer IBM High bracket taxpayers tend to be more interested in tax exempt bonds than those with lower incomes.

46. Corporate Taxes • Similar in principle to personal taxes: total income is revenue • Earnings Before Tax (EBT) is taxable income • Corporate tax rates do not consistently rise as taxable income rises

47. Table 2-5 Corporate Income Tax Schedule The rate increases from 34% to 39% and 35% to 38% recover the benefitof lower rates on earlier income. So a corporation earning more than $18,333,333 pays 35% on all of its income from thefirst dollar.

48. Concept Connection Example 2-6 Corporate Income Taxes Calculate the tax liability for corporations with the following EBTs: a. $280,000 b. $500,000 c. $16,000,000 d. $23,000,000 SOLUTION: a. Applying the corporate tax table to $280,000 yields the following: $ 50,000 × .15 = $ 7,500 $ 25,000 × .25 = 6,250 $ 25,000 × 34 = 8,500 $180,000 × .39 = $ 70,200 $ 92,450 b. Between $335,000 and $10 million the overall tax rate is 34% so the tax on $500,000 is $500,000 × 34 = $170; 000

49. Concept Connection Example 2-6 Corporate Income Taxes c. We don’t have to go through the calculations in the bottom brackets because we know that the system recovers those benefits to an overall 34% up to $10 million. $10,000,000 × .34 = $3,400,000 $ 5,000,000 × .35 = $1,750,000 $ 1,000,000 × .38 = $ 380,000 $5,530,000 d. Over $18,333,333, the tax is a flat 35% of all income starting from nothing, so the tax on $23,000,000 is $23,000,000 × .35 = $8,050,000

50. Corporate Taxes • Taxes and Financing • The tax system favors debt financing • Result: A debt-financed firm pays less tax than an identical equity financed company • But the availability of debt is limited because it makes the borrowing company risky